Hercules Capital, Inc. (HTGC) Q1 2016 Earnings Report, Transcript and Summary

Good afternoon, ladies and gentlemen, and welcome to the Hercules Capital Q1 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Mr. Michael Hara, Senior Director of Investor Relations.

Thank you, Nicole. Good afternoon, everyone, and welcome to Hercules' conference call for the first quarter 2016. With us on the call today from Hercules are Manuel Henriquez, Founder, Chairman and CEO; and Mark Harris, Chief Financial Officer. Hercules' first quarter 2016 financial results released just after today's market close and can be accessed from Hercules' Investor Relations section at htcg.com. We've arranged for a replay of the call at Hercules' webpage or by using the telephone number and pass code provided in today's earnings release. During the course of this call, we may make forward-looking statements based on current expectations. Actual financial results filed with the Securities and Exchange Commission may differ from those contained herein due to timing delays between the date of this release and the confirmation of final audit results. In addition, the statements contained in this release that are not purely historical are forward-looking statements. These forward-looking statements are not guarantees of future performance and are subject to uncertainties and other factors that could cause actual results to differ materially from those expressed in the forward-looking statements including without limitation to risk and uncertainties including the uncertainty surrounding the current market turbulence and other factors we identified from time to time in our filings with the Securities and Exchange Commission. Although we believe that the assumptions on which these forward-looking statements are based are reasonable, any of those assumptions can prove to be inaccurate, and, as a result, the forward-looking statements based on those assumptions also can be incorrect. You should not place undue reliance on these forward-looking statements. The forward-looking statements contained in this release are made as of the date thereof. And Hercules assumes no obligation to update the forward-looking statements or subsequent events. To obtain copies of related SEC filings, please visit sec.gov or visit our website, htgc.com. For today's agenda, Manuel will begin with a brief overview of our first quarter financial and corporate highlights, followed by an overview of the venture capital markets, and the state of new investment market opportunities, and our perspective and outlooks for the second quarter of 2016. Mark will follow with a broader summary of our financial performance and results for both first quarter 2016. And following the conclusion of our prepared remarks, we will open the call for Q&A. With that, I will turn the call over the Manuel Henriquez, Hercules Chairman & Chief Executive Officer.

Thank you, Michael. And good afternoon, everyone, and thank you for joining us today for the Hercules Capital first quarter 2016 earnings call. First off, I am very pleased and proud to announce another outstanding and very busy quarter for Hercules Capital in the first quarter. We're off to a very strong start in 2016 turning in a terrific financial performance and financial results for the quarter. Our outstanding team of investment professionals once again delivered an outstanding originations activity. With impressive total new commitments funding a net portfolio growth driving us closer to our target of $1.3 billion to $1.5 billion total investment loan portfolio by the second half of 2016. This of course is subject to March conditions remaining favorable. In addition, we have been actively building and expanding our various sources of liquidity by bolstering our balance sheet to ensure continued access to a healthy supply of liquidity positioning us well as we turn our attention to the second quarter of 2016 with a strong balance sheet, solid core yields, solid ROAA and solid ROEE financial results and having plenty of dry powder to make new investments as we continue to drive earnings and investment portfolio growth. Now, let me take a brief moment to highlight some of the key financial results and financial - and key messaging points that I like to have share with you on this call. We started the year with a solid first quarter performance, achieving our targeted net investment loan portfolio growth. Our growth expectations for Q1 was for net portfolio loan growth of approximately $75 million to $100 million, and indeed, we achieved that. We achieved $90 million of investment net portfolio growth in our portfolio, above the midpoint of the range. Our target portfolio growth of $90 million places that much closer to our desired investment portfolio target of $1.3 million to $1.5 billion. As many of you may recall, that is the optimal point to which we start generating net investment income covering our dividend from earnings themselves. We are now within $60 million to $110 million from that target which maybe close in Q2 or early Q3. Although deal flow was very strong in Q1 as evidenced by our outstanding performance of $220 million of new commitments, we're being a bit more cautious entering the second quarter of 2016 as we look to be extremely selective in new investment opportunities as we continue to deploy our remaining liquidity to new high growth venture-backed companies that must achieve the credit standards that we are comfortable with in underwriting. In addition, we're beginning to see some early signs of select tightening of yield in the marketplace and loosening of credit terms. Although not yet systemic, it is a pattern that is developing that we are keeping our eyes on. I will not say that we expect to see a tremendous amount of competition lowering yields, but we are seeing some entrants and some impact in that going into Q2. So, these new entrants in the market are new venture lenders which have little to no experience in the asset class. Those lenders are seeking higher-yielding assets than you'll otherwise see in the lower middle market space by entering venture lending. We're also seeing a resurgence in activities from some of the existing venture lending banks in the marketplace who are seeking to convert their growing deposit bases into assets or loan growth to provide greater NIM coverage. The majority of this increased environment is seen in loans under $15 million in size. That is a very important distinction that I want to highlight. Typically, much more competition is seen on loans between $3 million to $7 million and an additional increase, albeit less, between $7 million to $15 million and then, ebbing a little bit after that above $15 million, which is where we typically actually invest our activities [ph] today. We're also beginning to see, albeit anemic, some early indications of potential early loan repayment activities showing size of increased competition, which also lead to potential early payout activities peaking up. However, we do not expect early activities to really take shape or hold until later part of the second quarter or early in the third. I would like to caution it's extremely difficult for us to have very strong perspective as to when this early activities will take place. And typically, we only have anywhere between 2 weeks to 30 days in advanced notice before we actually get notified by our company from early payout activities. This potential pickup in early repayment activities represents an increase in our expectations to which we were only expecting to see approximately $50 million of early repayment activities for each of the quarters in the first half of 2015 - 2016 which tend to emulate the same activities that we saw in 2016. With that, Hercules now is revising its early payout activities expectations for Q2 2016. We have adjusted slightly downward our initial expectations of new investment growth in the portfolio from $75 million to $100 million initially anticipated to a more conservative outlook, albeit small, of $50 million to $90 million in new net loan growth in the quarter again driven in part by the expectation of a slight increase and early portfolio payout activities from more mature later stage companies in our portfolio. We then find that many of these new entrants or competitors entering the market lack any depth or experience in fairly understanding on how to properly underwrite venture loan risks. Many are inappropriately mispricing and granting less than optimal terms and conditions in their desperate quest to secure new loans or asset growth. Having been doing this now for nearly 30 years, and having seen this play out throughout my career many, many times, it's only a matter of time before many of these ill-experienced new entrants begin to realize credit losses from the ill fate of underwriting loans to which they have very little experience in understanding the cycles of life sciences companies or that of technology companies. With that, we have chosen to remain more cautious and more selective and refuse to match the rapidly tightening yield in certain segments of the market and allow assets to simply not fall into our lap as we pursue new investments as competitors drive margins slightly tighter than we think are appropriate in the marketplace. Because of this current cycle, our preference is to pass an ill-price or ill-structured loans. We will continuing to do as we did in Q3 and Q4 and that is preserve our liquidity for originating in better times we see widening yield and better terms and conditions that we like. We rather protect our balance sheet although I want to caution, this does not mean we will remain active in the portfolio of growth in Q2. As I said earlier, we expect the portfolio continue to grow to $50 million to $90 million in Q2 alone. So, we are continuing to grow our portfolio just being much more selective in that process as we look to have pricing equilibrium returns that to the marketplace itself. Now, although it's still early in the second quarter, we are now expect the early path activities again to now modulate themselves in a much tighter range of between $60 million to $80 million in early portfolio payoffs during the quarter. That is up slightly from our initial expectations of $40 million to $50 million. You can basically look at it as one to two additional loans simply paying off earlier than expected. But at this point, again I want to caution, we do not have solid visibility in that level yet. We're just seeing some noise level that we want to be cautious about and share with our shareholders on the activities that we're seeing. We will remain and continue to remain highly selective in our new origination activities. We will continue to adhere to our philosophy of slow and steady and prefer to slow down our portfolio growth to that new modulated growth level of $50 million to $90 million in the quarter. We will wait for the desired yields to fall onto place. Finally, given the challenge that many of our BDC peers are encountering today, I would also remind our investors and new investors evaluating Hercules Capital that we do not have nor do we focus on oil and gas exposure, and we do not have any CLO exposure in our book. That is an important differential between us and our BDC comparative companies out there. Now, what does Hercules Capital focus on and what we do and what we do well? And that is focused on the venture capital industry. We are the largest BDC focused on the venture capital industry bar none. We are extremely active. Our brand, our reputation, our integrity have afforded us and continues to afford us a very solid source of deal flows and very strong venture capital and private equity relationships with our financial partners for continued deal flow as evidenced in our $223 million of deals completed in the first quarter. Hercules shall remain focused on the venture capital marketplace and specifically focused on later-stage venture growth stage companies, companies that are expected to potentially achieve excellent liquidity events typically within 36 to 48 months post our investment with these companies. We expect many of these companies to achieve IPO or M&A event within that period of time. However, not all companies are expected to achieve those goals as many of these companies will continue to go through an elongated financing cycle as the continued growth to their clinical trials at their life sciences companies or continued development of their products, as we continue to improve those products once they're deployed in the marketplace with their own customer feedbacks. Now, let me share some key achievements as provided by Dow Jones VentureSource on the venture capital marketplace and venture capital activities. Surprising to us, as well as to me, the venture capital had an extremely robust first quarter of fund raising. In Q1 2016, the venture capital's firms raised approximately $13.3 billion of new funds compared to $35.2 billion raised in all of 2015. So if we assume a continuation of the Q1 activities run rate, VC fund raising may actually surpass all of 2015. However, Hercules does not expect that to occur. We expect VC fund raising to taper off and realize more in line, with the activities realized in 2015 or slightly below the 2015 activities at $35 billion. Now turning my attention to venture capital investment activities. This is well, was much higher than we had anticipated. I'd like to remind everybody that we had anticipated that the venture capital activity in 2016 will actually modulate itself down to around $45 billion of activity, down from the $75 billion that we witnessed in 2015. As to Q1 2016 specifically, the venture capital once again showed a healthy pace of new investments at $13.4 billion of new investment activities to over 800 companies receiving new capital by the venture capital community. That was much healthier and much higher than we had anticipated in new investment activities, but that said, I'm very to be pleased to see that activities. As representative, a lot of those companies happened to be our portfolio of companies that are seeing follow-on capital from the venture capitalist investments. As a reminder, many of our venture capital backed companies typically and are required to raise capital in generally 9 to 14 month intervals. As we typically see in our portfolio, turning our attention to Q1, we start seeing a significant activity pickup in many of our companies going out for financing events in Q1 and Q2, which leads to our own self-marking down of rated 3 loans to reflect the ongoing plans and activities of our company and key towards our nature of conservative mark-to-market in our loan portfolio. Other encouraging news from the venture capital activities was the biopharma investments activities. To our surprise, we saw a pick-up in biopharma performance in the second half or the later part of Q1 and certainly in the first half of the second quarter of 2016. In Q1, biopharma had seen strengthening or heightened investment activities by the venture capitalists, and I'm also happy to report that we saw a pick-up in investment activities in the venture capital community and to information technologies and electronics. We also saw, however, a pullback in consumer services more commonly known as social media-type investment activities by the venture capitalists themselves. Although IPO activity remained tepid to almost non-existence, we did see, however, six companies complete IPO events in the first quarter. Six of those companies just so happened to be life sciences companies. Later in the quarter, we also one technology IPO company complete an IPO and that’s SecureWorks which is basically a Dell spinoff itself. We however did not experience any IPO activities during the quarter. We ended the quarter, however, with approximately four companies in IPO registration. We did, however, see a pretty healthy pickup in M&A activities by the venture capital community with 131 companies completing over $22 billion in value acquisitions and activities in the quarter. That compares a total of $58 billion in all of 2015 of companies completing M&A event. So, as you'll see, the M&A activities in Q1 was actually more robust than many of us expected and quite encouraging signs of liquidity events are still occurring for the venture capital community. Now, let me take a moment to highlight our own capital markets and increased liquidity activities thus far in the early part of 2016. As most of you now will see, we have been very, very actively busy. We have recently bolstered and expanded, as well as diversified our multiple sources of liquidity to Hercules Capital to continue to sustain and gain access to the capital markets for continuation in portfolio growth. For example, we recently completed a top-off or a re-opening of our existing 20 2014 bonds of raising gross proceeds of nearly $73 billion and net proceeds of just over $70 billion of net proceeds. That is critical in adding to additional liquidity. We've also extended our relationship, and our accordion with Wells Fargo Bank. We now have added a second bank that’s in the game, for additional $45 million of liquidity being added to our Wells Fargo accordion, topping it off of $120 million of additional liquidity event for our accordion for additional growth in our portfolio. Also and a very strategic importance is that we also reinstated and began to selectively tap and use our at-the-market or ATM equity line. I view this line as a just-in-time additional capital being raised - equity capital being raised to allow us to keep in balances, our bank warehouse lines as a drop in new loans that sometimes the loans are lumpy in size. And by allowing us to have equity buffer for these ATM excess that allows us to basically manage our ability to stage in new loans into our bank syndicate. Please, be assured that the ATM is not a large equity capital raisin engine. It is meant to and use for just-in-time capital for small amounts of capital that's being raised and, in fact, to give you some comfort, that all of the equity raises that we done thus far, $15 million, have all been done absolutely accretive to net asset value and accretive to earnings themselves. This is a very effective treasury management tool that you will expect us to continue to utilize throughout the year. Again, as I said, since reinstating the ATM in early March, we completed a mere $15 million of equity offering all accretive to book and all useful and having us being able to manage our bank lines as well as our leverage ratios if, in fact, we need to be focusing on those issues at this point which we do not. We currently have a leverage of regulatory leverage ratio of only 58% overall. Said differently, we have an abundance of headroom to be able to grow our regulatory leverage up to a 1:1 level if we so choose. We ended the quarter with approximately $120 million. But not for the additional liquidity activities that occurred right after the quarter, we're now on a very fortuities position to have approximately over $200 million of available liquidity to continue to grow our investment portfolio. As a reminder, I said earlier, we merely need to grow it by $50 million to $100 million before achieving the optimal $1.3 billion to $1.35 billion. Said differently, we're extremely well positioned, from a liquidity point of view, origination activity and portfolio pipeline insight, to actually hit that target relatively comfortably. This is important because we technically do have that headroom to access additional leverage. We still reserve the right and the ability to tap the debt capital markets further in the near future to refinance our more expensive 7% baby bonds that we have outstanding that we are looking to refinance at much more attractive lower rates. However, short-term rates currently remain highly volatile and not optimal for us to pursue that. So, as we invest, we also manage our liabilities with the same level of prudence that we shall remain in the sidelines until we see a more favorable debt capital markets activity where the five-year treasury tends to stabilize a bit more than it is today. Because of that, we remain very patient and refinancing those old legacy bonds. I hope and expect to have those bonds refinanced sometime in the later part of 2016, but again, we remain cautious on that. Lastly, on leverage. I'd like to remind everybody, although we are able to leverage the balance sheet to a full 1.26-to-1, we will not do that. Our optimal leverage that we feel comfortable with is at 1.1-to-1 ratio or optimally somewhere in the neighborhood of about 1-to-1 leverage ratio themselves. Because of our ATM, we're able to manage those leverage ratios much more closely with the use of gradual issuance of equity, if we need to, to help us modulate down those leverages in the case of rising higher than we anticipate those to be doing. At this point, we want to make sure that we will only look at future equity raises if it makes sense and they become accretive in the short-term for us today. We have plenty of capital to grow and achieve our goals currently today. Now, turning my attention to the second quarter and summary of my comments. Hercules Capital is extremely well-positioned entering the second quarter and the second half of 2016. We have ample access to both debt equity capital markets for liquidity; we have an active ATM program that provides a just-in-time capital on a non-interest basis; we have been recently assured and have received affirmation from the rating agencies on our recent bond offerings; and also, all of our existing bonds now have a BBB plus rating from KBRA; and we also have investment grade rating BBB minus from S&P in all of our existing listed bonds today in the marketplace. In addition, Hercules continues to trade at a premium to net asset value, as compared to the broader B2C market which currently trades at a significant discount in an asset value. I would personally like to thank our shareholders for the continued faith and confidence in our team and our underwriting, allowing us to continue to trade at a premium to net asset value. We take this very seriously, and we work hard to ensure that we return that with strong financial performance for our shareholders, and continue to share our earnings growth for our shareholders. Hercules is only one of a handful that consistently and continue to trade above net asset value. With that, I turn the call over to Mark.

Thank you, Manuel. And good afternoon or evening, ladies and gentlemen. I will now briefly discuss our financial results for the first quarter of 2016 and add some context to the reported numbers. As Manuel commented, we had a strong Q1 2015, and I will give some direction on what we expect to see going forward. As we turn the portfolio of growth, our loan portfolio added cost increased from $1.152 billion at the end of 2015 to $1.242 billion at the end of the first quarter or an increase of 7.8%. We had strong total investment fundings of approximately $170.9 million in the first quarter, including the addition of 14 new portfolio companies, partially offset by $55 million of unscheduled early payoffs and normal amortization of $21.4 million. Our effective yields were 13.2% in the first quarter, down from 14.2% in the fourth. This decrease as Manuel have spoken to is primarily related to the amount of early payoffs and associated accelerated of interest and fees as previously discussed. We had early unscheduled payoffs of $105.5 million in the fourth quarter last year, compared to $55 million in the first quarter of this year. That's a reduction of approximately of 48% which was in line with the expectations at the end of the year. Given the current market condition and the age of our loan book, we expect to see $60 million to $80 million of unscheduled early payoffs in the second quarter of 2016. Core yields which exclude the effect of prepayment penalty fees and acceleration from early payoffs was 12.9%. This was in line with our expectations given the Federal Reserve's benchmark rate increase made in December 2015, coupled with 93% of our loans are variable interest rate loans. We expect our core yields to remain the same between 12.5% and 13.5% on a going forward basis. In the first quarter of 2016, we saw an increase in our weighted average loan yields on new originations due to one, an increase in the benchmark interest rates; two, a favorable competitive environment; and three, increased demand which led to origination of core yields of over 13% in the first quarter. It should be noted that while we saw better underwriting of turns and yields, our weighted average loan-to-value based on last round of financing was approximately 15% on a static pool basis for our portfolio as of March 31, 2016. This was an improvement from our year-end loan-to-value of approximately 16% based on the last round of financing. Before going to the income statement, I would like to remind everybody that Hercules Capital continues to adhere to its historical aversion to PIK. PIK is less than 5% of our total investment income in the period. Thus, PIK is a small part of our business as we believe in our amortizing loan policy to help prevent credit concerns down the road. Turning to the income statement, our investment income was $38.9 million in the first quarter compared to that of $39.4 million in the fourth quarter of 2015. This difference is mainly attributable to the large one-time acceleration of income in the fourth quarter. This acceleration stems from the $105.5 million of early payouts compared to the $55 million of unscheduled early payments we received this quarter. Removing acceleration from both quarters, we had an increase in our core investment of approximately 3% or $37.9 million in the first quarter compared to that of $36.9 million in the fourth quarter. Interest and fee expenses was $8 million in the first quarter compared to $9.5 million in the fourth quarter, a reduction of 15.5%. I'd like to remind everybody in the fourth quarter, we had a onetime, non-cash charge of approximately $800,000 related to the $40 million buyback of our September 2019 notes. Further, the $40 million buyback saved the firm approximately $700,000 in interest and fee charges. Thus, this had an aggregate savings of approximately $1.5 million, which accounts for the difference between the two periods. Subsequent to quarter end, we issued $72.9 million of our $6.25 million 2024 Baby Bonds. In connection with this issuance, we expect an increase in interest expense and fees on a quarterly basis of approximately $1.2 million. Therefore, we expect interest expense between $8.5 million and $9 million in the second quarter and between $9 million to $9.5 million in the following quarters subject to credit facility usages. Our weighted average cost of debt decreased from 6.2% in the fourth quarter to 5.5% in the first quarter of 2016. Given our $72.9 million bond offering, we expect our weighted average to increase to about approximately 5.7% on a fully burden basis going forward, again, subject to credit facility usage. Net interest margin was $30.9 million in the first quarter in 2016 compared to $29.9 million in the fourth quarter. Net interest margin adjusted for the effects of income acceleration of onetime non-cash expenses would have had a normalized level of $28.2 million in the fourth quarter versus $29.9 million in the first quarter or growth of approximately 6%. Net interest margin as a percentage of average yielding assets was consistent at 10.1% in the first quarter of 2016 compared to that of 10.2% in the fourth quarter of 2015. I'd now like to turn my attention to the operating expenses. Operating expenses excluding interest and fees increased to $10.8 million in the first quarter from $9.8 million in the fourth quarter or an approximate change of 10%. We expected our operating expenses at the end of last year, excluding interest and fees, to maintain between $10 million and $11 million per quarter as this gets adjusted on variable bonus tied to Hercules performance. Our first quarter 2016 was well within that range that we gave. Our general and administrative expenses in the first quarter was $3.6 million compared to $4.5 million in fourth quarter last year. This is within the range we gave for 2016 and that we expect to maintain between $3.5 million and $4 million on quarterly basis in 2016. Employee compensation increased to $7.3 million in the fourth quarter of 2015, $5.3 million due to changes in variable compensation from the quarter. We expect employee compensations to move in line with originations and business performance as it's directly correlated with our variable bonus program. Again, consistent with year-end, we expect employee compensation to be between $6.5 million and $7.5 million in 2016 for quarter. Our net investment income was flat at $20.1 million for both the first and fourth quarters which was due to the increase in interest income and a lower fee income due to last early unscheduled payments. On a per share basis, NII in the first and fourth quarter were both $0.28 per share. However, NII margin has improved to 51.6% in the first quarter compared to 51.1% in the fourth quarter which we expect to maintain between 50% and 52%. Our return on average assets was 5.9%. Our return on average equity was approximately 10.9% in the first quarter. This is in line with, again, the guidance we gave of return on average assets to be between 5.5% and 6.5% and return on average equity to be between 10% and 12% on a going-forward basis. We had a net change in unrealized depreciation on investment of $1.3 million in the first quarter. For further details on changes in unrealized depreciation, we direct you to our press release. We provide a detailed table which illustrates component about the credit and mark-to-market rate adjustments. As pertaining to our loans during the period, our loan portfolio had an unrealized appreciation of $6 million in the first quarter compared to unrealized depreciation of $10.5 million in the fourth quarter. This was a mix of gains from reversals and payoffs, impairments and market yield adjustments under fair value accounting. And our equity and warrants, our net change and unrealized depreciation was $7.4 million in the first quarter. Given approximately 35% of our equity and warrants are public, this is consistent with the first quarter capital market performance where we saw an approximate 8% decline in value in the quarter. For example, Russell 2000 Biotech Index was down 29% in the quarter. The Russell 2000 Technology Index was down approximately 2% in the quarter. And if we look at narrow index such as the S&P Pharmaceutical Bio & Life Sciences Index, that was down 8%, and the S&P Information Technology Index was up approximately 2%. Now turn our attention to credit analysis. For the respective credit volumes, we continued our focus on credit discipline. In the first quarter, our weighted average loan rating was 2.17 from 2.16 in the fourth quarter 2015, thus flat quarter-on-quarter. Although we did see an increase in rated 3 loans, much of it had to do with our portfolio of companies approaching an upcoming next round of financing event where we have a policy of moving them to a 3 grading until they complete their next round of financing, have a signed term sheet or other factors are present. I'd like to highlight that our watch list, which are the rated 3 to 5s, was approximately 23.5%, which is within our historical levels. Our non-accrual as a percentage of total investment income at cost decreased from 3.8% to 3.7% in the first quarter. While this decrease was modest, we did have two loans we exited within the quarter, coupled with the addition of one loan. We continue to work on our non-accrual to further reduce our rate over the next couple of quarters. Our cumulative net losses which consist of loan losses offset by equity and warrants, gains was $11.3 million since the inception of Hercules Capital, which is an outstanding number given the nearly $5.9 billion of commitments we've had to date, or loss of only 2 basis points annualized. As we discussed previously, we will continue our stringent focused on keeping cash drag and interest expense to a minimum, through the use of our credit facilities which were expanded in the quarter. Thus, we had unrestricted cash of $13.5 million at the end of Q1. We had $122.5 million of liquidity at the end of the quarter, which consisted of $3.5 million of unrestricted cash plus $109 million of undrawn availability under our revolving facilities subject to borrowing base leverage and other restrictions. Additionally, in April and May, we have four capital events that changed our liquidity profile to approximately $200 million. We closed $72.9 million on our 6.25% 2024 baby bonds in May, we added EverBank to our Wells Fargo facility which added another $25 million in April, we closed $4 million of ATM in the month of April, and we paid back the $17.6 million of our convertible bonds in April. Our unfunded commitments are now $162.6 million in the first quarter which consists of both available and unavailable or milestone achievement commitment. We had available unfunded commitments of $64.6 million or 5.2% of our loan balance at cost as of Q1 2016 which was a reduction from the $75.4 million or 6.5% of our loan balance at cost as of Q4 2015 which is significantly down from the $159.1 million we had in Q2 2015. We expect that our current unfunded commitments will stabilize at this level and may marginally grow with our business growth objectives. Turning our attention to our debt equity ratios. Our regulatory leverage excluding SBA as we have exemptive relief from the SEC was 58.6% at the end of the first quarter versus 57.2% at the end of the fourth quarter. Our GAAP leverage with SBA was 85.1% at the end of the first quarter versus 83.7% at the end of the fourth quarter. Based on the regulatory leverage ratio, we have the ability to add another approximate $300 million of debt without breaching the regulatory limit. Finally, net assets was $718.4 million at the end of the first quarter or an NAV per share of 9.81. While our net asset value - or net assets were up slightly, we did see a decrease in NAV per share by approximately 1.3%, mainly from the issuance of common stock under our RSA [ph] program and changes in our unrealized and realized activity in the quarter. Further, we continue to optimize our capital structure and engage in our share repurchase program and our ATM program. In January 2016, we repurchased approximately 450 shares at an average price of $10.64, and in March 2016, we issued 1.1 million shares at an average price $11.54. Finally, dividend. We're pleased to be declaring our 43rd consecutive dividend of $0.31 per share that will be paid on May 23rd as approved by our board of directors with the record date of May 16. With that report, I now turn the call over to the operator to begin the Q&A part of our call.

[Operator Instructions] Your first question comes from the line of Ryan Lynch from KBW. Your line is open.

Hey. Good afternoon and thanks for taking my questions. You mentioned that you guys are seeing increased competition in smaller loan size, let's call it, $3 million to $15 million, a little more competition on $3 million to $7 million loan size. So as I look through your portfolio, I mean they're quite a bit of loans, under $15 million in loan size. So can you just talk about how you guys are managing and trying to grow, have good net portfolio growth over the next couple of quarters meanwhile trying to stay away from the increased competition that's residing right now in the sub $15 million VC loan market?

Thanks, Ryan, for the question. As I said on the call, we just completed $220 million in the origination in the first quarter. So there is an abundance of deal flow and deal activity out there. We just wanted to highlight that there is a bit of more of increased competition coming in. But I think that the cadence that we are trying to establish of new portfolio growth of $50 million to $90 million is well within our capabilities as you saw on Q1. And we do not expect nor do we focus tremendous amount of time on those smaller deal size. But I would utterly caution you that some of the smaller loans you see there have amortized down, and those were not the original balances. If you look at our portfolio on a static basis, you're looking on an average loan portfolio around $13 million and $15 million on average size, and those balances you're quoting just so happen to be legacy loans that have amortized down since we don't really do $5 million or $3 million loans to speak of.

Okay. And then just sticking with the competition theme, it feels like over time, competition kind of ebbs and flows. You'll see a lot of new participants come in and then they'll kind of exit. It sounds like some new participants are coming in recently. How would you characterize competition currently versus maybe one year ago?

I think competition a year ago is much more sophisticated, understood the asset class much better. I think the competition today we're seeing is a bit more sporadic, ill-prepared to understand the subtleties of underwriting venture loan and development-stage companies. And I think that when they venture in, and I will use the expression all are welcomed because it only takes a matter of one economic cycle and one amortization period to commence when they start realizing credit losses when not knowing how to un-write this credit in venture lending. It's a very complex credit underwriting. It doesn't lend itself to some of the financial ratios that you will otherwise see more typically used in lower middle market. And you have to have both a good credit discipline background, as well as technology or life sciences make up in order to truly underwrite and understand these credits. So I am not losing sleep about this competition. I am not worried about this competition. It's both not sustainable and they don't have enough capital liquidity from what we're seeing. And a lot of the loans that they tend to be taking away our loans that we probably would not otherwise do. And we're in a very fortuitous position to have a very strong portfolio, a very strong legacy of underwriting good credit quality. And we only need to grow by, again, $60 million to $110 million to achieve our endpoint and we're very comfortable with that pace and that liquidity we have to achieve that.

Got it. And then just one more. I know VC access can come through a variety of different ways, M&A, also the IPO markets. But with the IPO markets essentially being close over the past few months, are you guys seeing any increased opportunity investing in some of the more later-stage of VC-backed companies that were maybe planning on IPOing and now cannot and are looking to raise additional rounds of capital?

So the answer to your question directly is yes. The clarifications, your question, I would say that for the last 16 years, I don't think we've had a robust IPO market yet. I think the last really good IPO market that we have was probably 1998, 1999. Ever since then it's been a fairly anemic IPO activity with some hopes of increased activities that we saw probably take place at 2014, if you will. But, yeah, most people don't realize - and it's not written - quite a bit about and that is that venture capitalists don't actually see an IPO market. M&A is better. And the M&A market has remained fairly steady and robust throughout that 16-year period of time. There has been, obviously, periods within than 16-year period of time where M&A is curtailed, but I got to be very honest. We continue to enjoy a pretty good representation, IPO activities, from our companies that are going on out there. And we're necessarily concerned about that. But to answer your question, yes, many of these later-stage companies who are facing potentially down-round valuation of an equity will be looking to supplement their capital structure with some form of debt, and we're evaluating some of those players, and we're passing on many of those players as well.

Great. Those are all the questions I had.

Thank you, Ryan.

Your next question comes from the line of Jonathan Bock from Wells Fargo Securities. Your line is open.

Good afternoon, and thank you for taking my questions. Manuel, I appreciate the comments about measured growth and more importantly, competition. And just to use a comment, I think that you mentioned letting the yields come to you. We respect that. The question centers, though, around the fact that earnings are still a touch life of the dividend. So, could you explain, if the yields aren't where you want and growth isn't where you want, why it's worthwhile to raise high-cost debt on the balance sheet, which puts us further away from dividend coverage in light of the fact that you're being so conservative? So, it seems that - help us understand how there is congruence there when at first glance the decision to raise the high-cost debt appears a bit incongruent.

Wow. Well, I want to be respectful, but I don't agree with almost all of that.

You can't and I respect that. I just want to understand what we're missing because when we put our high cost in on the balance sheet, we end up getting further away from target coverage if you're being conservative. Normally, we see folks try to lower interest cost at that time and will term things out kind of after we've built growth. Does that make sense?

No.

Okay. Because the answer is not all of debt is created equal, and I think this notion and this capitalizing of BDC with short-term bank lines is actually very problematic for me and one that raises all kinds of economic concerns for BDCs.

Okay.

Specifically, the reliance on short term bank line albeit optically looks attractive at 3.5%, 4% yield, if you will, or cost of capital, the reality is you're not getting a really attractive advance rate, especially of entry asset class where most typical banks will only advance 50% ratios on those bank lines. While a bond that, for example, which I disagree with it, they're not very expensive cost of bonds, I just borrowed eight-year money at 6.25% locked-in fixed while my bank lines are all short-term floating rate loans and variable in nature and allow me to have a spread that may expand and compress accordingly. So I'd rather leg out a maturity on my liabilities with the fixed rate liability. So let's take that at face value. So if I'm originating loans that effectively will a 13-plus yield today and they have cost of capital, in this case, cost of funds at 6, I'm getting a 600 to 700 basis point wide spread on that. And that's very attractive when actually matched by maturities on a long-term debt facility itself. When I blend that in to my entire liability structure, my blended overall liability is actually still exceptionally attractive around 5.5%, 5.6% on a weighted basis. So all that serves to be accretive. What people don't potentially realize is that your reliance on bank clients albeit is important from a short term financing facility, you're not able to achieve the optimal advance rates under your bank lines because of single credit concentration limit. And other restrictive provisions that exist within bank clients. Thereby allowing bonds to be much more attractive and fluid in building a very good robust portfolio. And I will always defer to long term type of financing in the bond markets than merely relying heavily on short term bank clients.

Got it. So then just taking that and I appreciate that because that's a comment about advance which is very important. So then even blending this higher expense into the cost structure your views of easily covering the dividend from NOI I mean, that would kind of say that we should expect that near term fairly shortly?

Absolutely. I've said this all along in Q3 and I've said it in Q4 and I'll say it again now. I absolutely believe borrowing some black swan event that this team will deliver that NII coverage which to me is more symbolic than reality, and the only thing that I really care about is taxable earnings which have been covering our dividend for a long time as we had earnings spill over. But that said, the street is fixated on NII to div coverage, dividend coverage. I hear you, I know that, and I can tell you that as I said this early on and I'll say it again now. Once we achieve that optimal utility of our portfolio that $1.3 - $1.35 billion, subject to whatever the yield you want to use, you will more than see that $1.350 billion were generating income that more than surpasses the $0.31 dividend yield. That is expected to be achieved probably sometime in the third quarter whether it's at the middle or the end of the third quarter. That is the trajectory that we are on, and I expect us to achieve that trajectory barring some black swan events. So, yes, that is what we're marching towards, and that is what we will do borrowing some of that.

Got it. And then probably just to keep focused on the liability, [indiscernible], but obviously with such large scale and presence, the choice between line at low rate versus term debt at higher rates, but not secured, provide financial flexibility, isn't there a third avenue that relates to on balance sheet securitization? And I mean - and that likely attractively priced credit not as longer term but certainly matched to the duration of your assets, can you talk about that tool and its potential for use in the current market environment?

Yeah. I'll let Mark answer that in more details, but the answer to that is that Hercules prides itself on having a highly diversified source of funding. Securitization is very much in, that wheelhouse, and you're absolutely right on your comment. Mark will cover that in a second. But that is something that we'll be looking at as well, but I'll let Mark give you more color on that.

Jonathan, it's a great question. The answer is, first of all, no stone goes unturned. Okay. So we're absolutely looking at potential securitizations. We're looking at unsecured. We're looking at - as we've done expanding our facilities, et cetera, and we're trying to make sure we've always got the right mix on our liabilities. I guess the comment that I would make is very complicated in the sense that, hey, you've got to put assets behind it. You've got to make sure it has the right makeup and mix, and you're getting the right yields and advanced rates, et cetera. And it's always a very careful game that you have to play with, but also remember its variable. It's going to move on you especially at a rate increase environment. So today, well it may look really inexpensive. If you start going along on it and the others, where you could fix yourself in like we did on the eighth year, that 6.25%, I'll take that all day long. On the securitization standpoint, is we're seeing some pretty large spreads on those. So, those can go anywhere from 350 to 450 or higher, and we just believe at least the market feedback that we're getting on them, they're not right for us at this point in time, but hey, if it that changes next week, definitely, I'll reserve my answer.

And Jonathan, please take this at face value. We will be doing a note securitization. As we once again top off our bank lines, we will then term out those bank lines, i.e. warehouse facility into a longer-term duration securitization facility. And that will be happening probably later on in 2016 as well.

Makes total sense. Thank you so much.

You're very welcome.

Next question comes from the line of Hugh Miller from Macquarie. Your line is open.

All right. Thanks for taking my questions. Wanted just to touch base a little bit on kind of - we've been hearing that the VC-backed companies have been shifting kind of focused towards achieving profitability as opposed to just really focusing on growing the business with the customer rate. In that type of a scenario where you'd probably see a slower cash earn rate, would you say that that impacts your ability to kind of deploy capital to some of those higher quality firms, if they're less cash drag or is that not a huge issue for you?

First of all, your question is actually - I appreciate it - quite insightful and very astute. But there's a difference in the answer. Actually, those companies are even more attractive to us, and we're more attractive to them. Because the fact of the matter is, although they are pulling back their burn rate and trying to concentrate on getting to a cash flow breakeven or EBITDA breakeven, they nonetheless still need additional working capital. And what they do in that case is minimize the impact on dilution by issuing more shares, thereby driving their EPS even lower. So what they do is they'll actually then complement lesser amount of equity to minimize the impact on that numerator of the number of shares that they're going to be issuing and then supplement that with debt capital to achieve the same level of working capital or new capital they need to fund their growth. So they'll actually be using much more debt in those cases to actually look to fund through a liquidity event and in near term and doing excess of equity. Although it seems very nice to be able to tell a company to bring $10 million a month, somehow you got to then go to cash flow breakeven within three months, the burn rate is down from $10 million a month to maybe $7 million a month, and six months later, maybe $5 million a month. It is very difficult for them to miraculously turn off this spigot of burn. So it takes about nine months or longer to get these guys to stabilize, and some of them will still be burning money, just burning at a lesser rate of money.

Definitely very helpful color there. Thank you for that. And following up on your comment about kind of preference for favorable M&A environment versus an IPO environment, is that just a function of kind of getting the liquidity out at the time of the event as opposed to a slower drawdown via IPO as you sell down the investment? Or are there other factors that play into a preference for M&A over IPO.

Sure. Listen, with no disrespect to IPO companies going out, the biggest risk with IPO companies are that you typically have an investment banking lock-up period of 180 days. Said in different layman's terms, you have two earnings calls. Post the IPO then, you got to pray and hope that they don't miss earnings. And therefore that's additional stock volatility. On an M&A event on the other hand, when M&A happens, we get either paid out or the acquirer assumes our debt with our consent. So, it is a much better liquidity event on M&A than potentially risk an IPO that where they may not choose to pay us down or pay us off at that point. We have many companies who go public who keep our debt outstanding. But we also have a smaller set of examples of companies who go public and do pay off our debt. But our preference, clearly, would be an M&A event. We actually get paid out. We don't have after-market risks either at M&A or IPO event that happened.

Yes. That's helpful. Thank you. And then, last from me, I heard a little bit about one of your peers that just had some challenges with their early-stage VC portfolio with an uptick in kind of some of their charge-offs. And I wanted to just get your sense, I know you guys focus on the later-stage market. But as we look back over history, and not to say that their challenges are a proxy for the early-stage market, but is there - does there tend to be a lag between if we do see challenges in early stage, is there a lag period in which it starts to impact later stage, or how does that relationship work through the cycle?

So, to use a metaphor, early-stage is not the canary in a coal mine. What happens is, is a very simple mathematical calculation. If I'm a venture capitalist and I only have $3 million or $4 million invested in an early-stage company, and that company is still seven years away from monetization of their products and services or monetization of an actual liquidity event as opposed to a later-stage company where I may have $30 million of equity capital as a single receipt and in totality may have $130 million, $150 million of equity capital, the expression that is used in this business is that the VCs are more willing to circle the wagon and protect that more capital-intensive company that they had if that company has a greater efficacy or proving that its business model is working. And thereby it will have to just simply withstand the current cycle that you're in, but it has a better optimal chance in going public than later, which means that you might as well cut and run on the earlier-stage company because you don't have enough capital risk there that really matters. Not to say that VCs do not care about those early-stage companies, but it's lot easier when you're faced with a capital constrained environment to simply say, I'm not going to really support that early-stage company.

Certainly makes sense. Definitely appreciate your insight. Thank you.

You're welcome.

The next question comes from the line of Aaron Deer from Sandler O'Neill. Your line is open.

Hi, good afternoon guys.

Hi Aaron.

A couple of questions one is it was nice to see the $12 million appreciation on the loan book. I'm wondering it's unfair we have to miss in terms of the credit outlook. I'm wondering what the potential pipeline, if you will, of additional write-ups might be to the extent that you'll see continued improvement in credit.

Well, we are actually - we obviously are taking what we know how to do well, and that is evaluate credit in a very rigid basis. As always, we think that our credit book is truly reflective of what's going on in the marketplace and what's happening out there. I think one of the things that you see in our portfolio is that many of our companies when they achieve an equity new raise, we will then remark up or reevaluate the mark on that portfolio company because they now have re-topped off the coffers with additional capital or, said differently, the risk profile has dramatically improved post the equity raise. As many of our companies are embarked on doing it right now, Q1 and Q2 is typically a fairly robust period of time for many of our companies raising capital. Hercules typically - unlike many other BDCs out there, we actually lower the risk rating in those companies until such time as they raise the new level of equity capital and then it's - in our minds, they go off risk again. We do not see clearly a disproportionate increase in the credit outlook or credit concern to our portfolio. I think that the credit portfolio march right now reflect what we think is a good outlook unless some, again, Black Swan event occurs in Q2. We think that we saw some nice resiliency of the biotech marketplace occur in Q1 albeit some pick up in technologies, but not anywhere near the pickup that we've seen in life sciences that occurred. Many of our companies, however, are in fact closing new rounds of equity capital. That is a good testament of our teams identifying and picking the right companies who are able to raise subsequent amounts of equity capital and get that additional amortization cash or capital to continue to pay down our loan. And that is a process that we see right now. But I don't see this disproportionate pick up my credit concerns right now in the marketplace, especially since we don't really do a lot of early-stage deals.

Okay. So it sounds as though, as these fundings come through, and you sound pretty optimistic that they will, that we could continue to see the mark-ups outweigh the mark-downs on the credit side.

The answer is yes. I believe it's from what we know today, and I think that that continued pace of continued improvement on a credit book should occur and will occur. As I've said, many of our companies are currently in the midst of raising new equity rounds capital. But only let's say, less than a handful, we have a closer scrutiny on those going on right now, but the vast majority have or are in the process of securing new rounds of equity capital which upon completion, will dramatically improve further the credit book than what it is today which is already quite strong. But yes, to answer your question, I don't have this great credit concern in the marketplace today. We are nowhere in 2007 and 2008, if that's what you're asking me. We're far from that today.

It's great. And then a question for Mark. You - if I heard you correctly in your commentary, you said that excluding the early pre-payment impacts, that there was a 3% sequential increase in core investment income. Was that right?

Correct. So what we did is we wanted to try to take the noise out of the numbers so you guys can understand how we did on a core basis. And the core basis, we grew from Q4 to Q1 by approximately 3%.

So the average loans over that period I think were up like 6%?

Correct.

And then, of course, you had the 25-basis-point raise hike. So, what are the variances there? Is it a lower deal than new investments or - and then there's some other accretive impacts that are [indiscernible]?

No, not at all. So the way that you want to think about it is, remember, we've got some that pay off, and we have obviously the ones that we've added on. On a - just on a core versus non-core, the answer is, as you add in ones that have a core value, that will increase the investment income amount, and that's really kind of what we've generated. That's why we saw the approximate $37 million from the $35 million increase that I was speaking to in the script because we're adding those new investments on board.

So, Aaron, let me take a stab this way. So what is going on in the portfolio is, as the portfolio continues to grow organically, we have less and less reliance on one-time events, fee-driven events in order to continue to grow earnings. What is happening is, because the lack of amortization - because the lack of early repayment activity going on, we're simply able to continue to add to the core portfolio assets that are generating yields at higher and higher rates as we're originating in Q1 and hopefully additional yields in Q2. As we have those new loans at a higher yield, our core earning capacity of that portfolio is going up itself naturally. Then what happens is, if you add the expected in the second half of 2016, early payout activities use the generating income that should far exceed the $0.31 in dividends driven by these early payout activities. But we want, and our focus is, to drive core portfolio growth minimizing the need for one-time income event to get to that $0.31. And if that happens, you'll have a portfolio that if the one-time events occurred, you'll be generating income well above the $0.31 by those one-time events that occurred. And that's exactly what we're doing right now. The slide that actually shows this core portfolio of earnings growth in the portfolio as we continue to grow the asset.

Yeah. No. I understand all that. I'm just - I'm trying to understand the dynamics just with - between the fourth quarter and the first quarter. And - because I thought that that core number that you were referring to, the 3% increase, excluded the impacts of the early pre-payment activity. But apparently, I must've misunderstood. I'll follow up with you afterwards on it.

Okay. Yeah. Sorry for the confusion that exists. Mark, I think he covered it, but we're happy to kind of provide you more color or more detail on that certainly.

I appreciate that. Thanks for taking my questions.

Your next question comes from the line of Robert Dodd from Raymond James. Your line is open.

Hi, guys.

Hi, Robert.

Hi. Going back to that competitive environment, if we can, for a second. Would you say there's any correlation between that increasing competition and the acceleration modest of early repayment activity? I mean, if I was a new entrant, the first thing I do is try and pick up loans you already underwritten the 200 basis points less because you probably are better underwriter than I am. I've been picking up your business. So is there any connection there? Could we see that accelerate or is that just unrelated and not a problem right now?

Well, I wish that we you just said actually occurs because by that occurrence, we're able to grow our portfolio and receive the benefit of their early repayment activities will further drive earnings and drive our earnings growth. So we'll happily - we actually love to see that happen on [indiscernible] assets. We've already said that. Maybe new entrants are noticeably able to distinguish good and bad credits whether it's from our portfolio or new loans their trying to originate. So what happens right now is that many of new entrants may not have the capabilities to take out the $20 million loan or $30 million loan that we may have in our books. So they're much more willing and able to pick up those loans that are much smaller than in our loan portfolio or go after the more aggressive stage of development companies in that $3 million to $5 million, $5 million to $7 million, $7 million to $15 million size which are more competitive, and then forego wider spreads. So, although competition will and may drive early repayment activities, with what we're seeing today, the new entrants that we're seeing don't initially have the balance sheets or the wherewithal to really take out larger credits of ours to make a difference. So, most of the credits that we may see paying off are not necessarily larger in size.

Okay. Got it. One housekeeping one for Mark or Manuel. On the core yields, you said you expect them to stay in the 12.5% to 13.5% range going forward. I mean will they be accurately inspecting the associated cost spread and obviously, if rates rise, those core yields would rise as well. Or does that factor in kind of yield expectations [indiscernible] expectations?

Clearly, 12.5% to 13.5% encompasses any expected future appreciation or accretion in yield that we may realize over time. So, that range, I think, is a comfortable one to speak to on that. What the earlier payment activities will occur or trigger would be an increase in activities in the effective yields and that can literally - depending on the size, a $20 million early repayment activity that generates a 2% early repayment could have as much of an impact of - depending on the vintage up to almost $0.005 in earnings accretion associated with it. So, it really depends on the maturity of the portfolio. One of the things that Mark said is the current LTV in the static agent portfolios are two very important indicators of the health and vibrancy of the portfolio we have presently today. And I'd like to call your attention now, when you look at our portfolio, we currently have an LTV of 15% in our portfolio and compared to a 16% LTV last quarter. So that's an important indication in terms of a lot of our companies have both recently topped off new equity rounds of financing. Very new entrances or very new loans that we originated rarely pay off quickly. These have a 3% pre-payment penalty typically associated with it. So it's not much of an appetite to take somebody out of a brand new loan. More older loans, certainly now have a much more lower pre-payment penalty, and that's where we expect to see a little more activity taking place. Unfortunately, some of those older loans may not really lead to a higher increase in the effective yield from those loans. And those are the ones we're seeing. But I want to be very clear here. We're talking about maybe a $20 million to $30 million potential increase in early repayment activities. And we're not saying that that's going to happen yet, but we are seeing some signs that that may happen. We will have better visibility on that as we complete Q2, and as I said in Q4, we certainly expected to see much more pick-up in early repayment activities in the second half of 2016, but we get to see some signs of noise level today. But again, it's very hard for us to have confidence levels on being very specific on early repayment activities currently today.

Got it. I appreciate it, fellows. Thanks.

I would now like to turn the conference back over to Hercules.

Thank you, operator. And thank you everyone for joining us on this call today. We're in the process of setting out numerous non-deal road shows in the month of May and June. I expect to be touring New York, Boston and Chicago right now. And we'll expand that to additional cities as we look at the schedules and investors' interest. Again, thank you very much. If you would like to schedule a meeting with us, please feel free to contact Michael Hara, available on Hercules website or directly by calling Hercules at our main office at Palo Alto. With that, thank you, operator and thank you, everybody.

Ladies and gentlemen, this concludes today's conference. Thank you for your participation and have a wonderful day.